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Integrity
Performance Service
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With the benefit of hindsight it is not difficult to understand the stock market’s negative reaction over the past three years. The years leading up to the new millennium were heady ones. New technologies proliferated. Wall Street analysts vied with one another to produce the most optimistic forecasts of growth. Money flowed freely to venture capital funds, created especially to invest in the new technologies. Capital spending by businesses expanded dramatically in the last half of the decade, as corporate America reacted positively to rising demand and euphoric forecasts. The federal government, too, was in an expansive mode. Flush with money from previously enacted tax increases and declining defense expenditures, government spending advanced sharply even as the national debt was paid down. Monetary policy was accommodative throughout the period, especially around the new millennium when, fearful of a meltdown, the Federal Reserve flooded the system with money. Inflation did not pose a problem. Indeed, the economic picture of the United States at the turn of the millennium appeared faultless. The ground was shifting, however, and change came with earthquake – like suddenness. The proximate cause of the economic slide was the announcement in the first quarter of 2000 of a decline in capital spending. Capital spending peaked in the third quarter of 1999 and began a relentless slide which only recently appears to be reversing. Job creation receded in the second half of 1999 and the decline accelerated in 2000, causing consumer spending to turn negative. Private debt suddenly was viewed as a liability rather than an asset. The equity market was extended as the new millennium began, with speculation rampant in the new issue market and the technology and telecommunications sectors. As has happened at the start of every period of economic contraction in our county’s history, people were shocked that an effervescent economy could stall so woefully and so suddenly. The National Bureau of Economic Research, the official arbiter of such things, places the start of the recession in early 2001. In reality, industrial production, capital spending, jobs, and consumer spending were all in retreat throughout 2000, while unemployment increased. The stock market peaked in March 2000, and has essentially mirrored the economic slide. While the mood of investors remains cautious and fears of terrorism and war remain high, the painful retreat of the United States economy is over. The lessons of history in many cases were lost in the long economic advance which ended in 2000, with painful consequences for investors. Some of these lessons bear revisiting. Primary among them is the wisdom of being conservative in asset allocation. One should never place funds in the stock market which might be needed to draw upon in the next year. Investing for growth and appreciation is a valid, time tested goal, but greed is not. In the short term the equity market is subject to too many variables for safe passage. Retaining sufficient liquidity in safe investments, such as money market funds or even saving accounts, enables one to take the short term swings with equanimity. An appropriate investment horizon for stock investing is a minimum of five years. Along with conservative asset allocation, expectations of returns must be realistic. It was not unusual around the turn of the century to hear investors talk of 20% or greater expected returns from stocks. Indeed, espousing conservative expectations was viewed in some quarters as advocating the equivalent of a flawed investment policy. In the long run, however, even the most rapidly growing industry is impacted by competition and bounded by economic circumstances. Excellent analysis and selection can improve rate of return potential but growth rates over time must recede. The best guide for future expectations of stock returns is the lessons of history. Over the long term, equities in the United States have earned around 10% with at times, wide variations. There is no reason to think that returns over the long run will be different than the historical norm. The lesson learned from the collapse of the technology and telecommunications stocks is diversification. Conscientious analysis can lessen the odds of selection error, but in a dynamic, ever changing environment it cannot guarantee success. Effective diversification sharply improves the odds against serious loss. A word of caution is appropriate however. A friend owned shares in all the fiber optic companies during the heyday of their popularity, arguing vociferously that he was effectively diversified by spreading the risk among numerous companies. Of course when the entire industry imploded his investments were very badly damaged. Effective diversification does not mean owning more stocks. It means owning companies which respond differently to evolving economic circumstances. It is the opposite of concentration. Perhaps no investment practice was undermined more seriously in recent history then momentum investing. Momentum investing is the opposite of investing on the basis of sound fundamental approaches. Essentially, momentum investing is driven by euphoria and is intoxicating in its promise of easy money. Momentum alone carried the technology sector to a 35% weight within the Standard & Poor 500 Stock Average in early 2000, from 12% and 17% at the beginning of 1999 and 1998, respectively. There is simply no market environment that justifies momentum investing as a substitute for judgments based on sound, fundamental analysis. Many investors did not sell their failed investments even after news of fraud, deceit, or egregious self dealing became known. When an investment turns bad with little hope of recovery it should be sold. This is often bitter medicine to swallow, but taking losses is necessary for one to move on. Holding positions in stocks which have turned irretrievably bad is one of the major causes of wealth destruction. More than any "think tank", whose charge it is to gaze into the future and predict outcomes, more than any of Wall Street’s famous prognosticators, the U.S. financial markets are accurate barometers of the health of the nation. This uncanny sensitivity to economic trends arises from our free market system. It is a healthy system, providing new jobs and opportunities for advancement not available in any other economic system. As with any system born and sustained by freedom, however, it is prone to cycles and periods of excessive optimism as well as excessive pessimism. Investors have to be prepared for the bad times as well as the good times, or else history will surely continue repeating itself. Investment Policy Committee Alfred A. Lagan, CFA, Chairman December 2, 2002 The opinions expressed herein are those of Congress Asset Management and are subject to change without notice. 2 Seaport Lane Boston, MA 02210 www.congressasset.com
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